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Derivatives like futures and options are used by mutual funds for hedging their portfolio to manage their risk.
Margin account - As the exchange guarantees the settlement of all trades, to protect itself against default by
either counterparty, it charges various margins from brokers. Brokers in-turn charge margins from their
customers. Margins are payable by both buyer and seller.
Higher the margin/deposit, more the exposure amount available.
If the price of future contract increases, the buyer will have a notional gain and so his marginal account will
be credited by the notional gain amount. The seller will have a notional gain and so his marginal account will
be debited by the notional gain amount.
Specific risk or unsystematic risk is the component of price risk that is unique to particular events of the
company and/or industry. This risk is inseparable from investing in the securities. This risk could be reduced
to a certain extent by diversifying the portfolio.
Systematic Risk - An investor can diversify his portfolio and eliminate major part of price risk i.e. the
diversifiable/unsystematic risk but what is left is the non-diversifiable portion or the market risk-called
systematic risk. This can be reduced by using index based derivatives.
Value-at-risk is the expected maximum loss which may be incurred by a portfolio over a given period of
time and specified confidence level.
Hedgers face risk associated with the prices of underlying assets and use derivatives to reduce their risk
Speculators/Traders try to predict the future movements in prices of the underlying assets and based on the
view, take positions in the derivative market
Income or loss on derivative transactions which are carried out in a “recognized stock exchange” is not taxed
as speculative income or loss. Thus, loss on derivative transactions can be set off against any other income
during the year (except salary income). In case the same cannot be set off, it can be carried forward to
subsequent assessment year and set off against any other non-speculative business income of the subsequent
year. Such losses can be carried forward for a period of 8 assessment years.
If the position of a trader is not squared up till maturity i.e. the last thursday of the month then the position is
automatically squared up by the exchange by the closing price.
MTM - In futures market, while contracts have maturity of several months, profits and losses are settled on
day- to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM
margins) from the loss making participants and pays to the gainers on day-to-day basis.
Net amount received(credit balance in MTM margin account) being anticipated profit should be ignored and
no credit for the same should be taken in the profit and loss account.
Impact cost is what additionally a trader must pay because of the order size i.e. due to price increase if there
is a big buy order or decrease if there is a big sell order
Carrying cost, in equity derivatives, is the interest paid to finance the purchase minus dividends earned.
Cost of carry model is future prices = spot price + cost of carry
If futures price is higher than spot price of an underlying asset, market participants may expect the spot price
to go up in near future. This expectedly rising market is called Contango market
If futures price are lower than spot price of an asset, market participants may expect the spot price to
comedown in future. This expectedly falling market is called Backwardation market.
Operational risk is defined as the risk incurred by an organization’s internal activities
Off-Setting is the process by which a future contract is terminated by a transaction that is equal and opposite
to the original transaction
Initial margin paid by the seller of an option should be shown under current assets in the balance sheet.
Forex cannot be counted as liquid asset
There are minimum requirements to trade in the derivatives segment.
5 lakh contract minimum for future contract
Arbitrator passed the award in 4 months
If no shares are received in an auction, the transaction is closed out at a particular price. The close out will be
at the highest price prevailing in the exchange from the day of trading till the auction or 20% above the
closing price on auction day, whichever is higher.
A market-maker is a company/individual that quotes both buy and sell price, hoping to make a profit on the
bid-offer spread
Securities transaction tax is levied on purchase of equity shares and sale of derivatives.
Max brokerage charged by trading member in F&O is 2.5%
Difference between spot price and future price is called basis.
The Indian derivatives market has 3 underlying futures contract available at any given time
Tick Size is the minimum move allowed in the price quotation set by the exchange. Nifty has tick size of 5
paisa.
Day order: A Day order is an order which is valid for a single day on which it is entered. If the order is not
executed during the day, the trading system cancels the order automatically at the end of the day
Trading price limits define the maximum percentage by which the price of future contract can rise above or
below the previous day settlement price.
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Options
European option - The owner of such option can exercise his right only on the expiry date/day of the
contract. In India, Index options are European
For seller of Option
Seller pays margin, receives premium.
Max loss = Price - Premium, can be unlimited
Max profit = Premium
For buyer of Option
Buyer don’t pay margin, pays premium
Max loss = Premium
Max profit =
A Put option is in-the-money when the spot price is below the strike price.
When spot price increases, premium of put options decrease because difference
A Call option is in-the-money when the spot price is above the strike price. Intrinsic value for such an option
= Spot Price - Strike Price (Intrinsic value refers to the amount by which the option is in-the-money)
Time value = Premium - intrinsic value
In-the-money means that your stock option is worth money and you can turn around and sell or exercise it.
An option will only be exercised when it’s in-the-money
Only in-the-money options have intrinsic value, at and out the money have zero intrinsic value.
Option premium consist of two components - intrinsic value and time value.
Higher volatility means higher risk and higher risk means one has to pay higher premium.
Higher interest rate will result in an increase in the value of a call option and decrease in the value of a put
option.
Vega, is positive for a long call and long put. An increase in volatility of the underlying increases the expected
payout from a buy option, wethers its put or call.
If price of the underlying asset goes up the value of the call option increases while the value of the put option
decreases. Similarly if the price of the underlying asset falls, the value of the call option decreases while the
value of the put option increases.
If all the other factors remain constant but the strike price of option increases, intrinsic value of the call
option will decrease and hence its value will also decrease. On the other hand, with all the other factors
remain constant, increase in strike price of option increases the intrinsic value of the put option which in turn
increases its option value.
Beta = 0.9, buy position SBI = 3,00,000
What will give complete hedge?
Ans. - If nifty falls by 100, SBI will fall by 90 i.e. 10% less
So we need to hedge 10% less of nifty, 10% of 3,00,000 = 30,000
3,00,000 - 30,000 = 2,70,000 Sell of Nifty
Beta of a portfolio is calculated as weighted average of betas of individual stock in the portfolio based on
their investment proportion.
Delta is option price, given small change in the price of the underlying asset.
Delta = Change in option premium/ Unit change in price of the underlying asset.
Delta for call option buyer is positive.
Delta for put option buyer is negative
Gamma is change in delta with respect to change in price of the underlying asset. Also called second
derivative option
Gamma = Change in an option delta/ Unit change in price of underlying asset
Theta is the change in the option price given a one-day decrease in time to expiration. It is a measure of time
decay.
Theta = Change in an option premium/ Change in time to expiry
Vega is the change in option price given change in market volatility.
Vega = Change in an option premium/ Change in volatility
Rho is the change in option price given a one percentage point change in the risk-free interest rate.Rho
measures the change in an option’s price per unit increase in the cost of funding the underlying.
Rho = Change in an option premium/ Change in cost of funding the underlying.
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Spreads
Option Spreads
Spreads involve combining options on the same underlying and of same type (call/ put) but with different
strikes and maturities. These are limited profit and limited loss positions. They are primarily categorized into
three sections as: Vertical, Horizontal and Diagonal.
Vertical spreads are created by using options having same expiry but different strike prices. Further, these can
be created either using calls as combination or puts as combination. These can be further classified as:
Bullish Spread: Created by buying a low strike call and selling a high strike call
Bearish Spread: Created by selling a low strike call and buying a high strike call OR selling a low strike put and
buying a high strike put. Bear spreads involve either two calls or two puts but not a call and put.
Calendar spreads position is a combination of two positions in futures on the same underlying - long on one
maturity contract and short on a different maturity contract. It is computed with respect to the near month
series and becomes an open position once the near month contract expires or either of the offsetting
positions is closed. A calendar spread is always defined with regard to the relevant months i.e. spread between
August contract and September contract, August contract and October contract.
Butterfly Spread - Extension of short straddle, to put limit to its downside. Trader buys one out of the
money call and one out of the money put.
Various future contract positions in the same underlying are netted off before arriving at open positions.
This is because a long a short position in the same underlying will have no risk(if one will make profit, the
other will be in a similar loss) and only the open position will have risk and margins will be collected from
these open positions. Calendar spreads carry no market risks, hence low margins are adequate. They carry
basis risk - both contracts will not fluctuate identically
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Clearing Corporation
The clearing corporation monitors collection of initial margin and allows exposure to members based on that
Both trading-cum-clearing member and professional clearing members are required to bring in additional
security deposits in respect of every trading member whose trade they undertake to clear and settle.
Clients positions cannot be netted off against each other while calculating initial margin. Margin for each
client has to be paid separately as per their outstanding trade/position.
The clearing corporation can transfer client position from one broker member to another broker member in
the event of default by the first broker member.
In a derivative exchange, the networth requirement of a clearing member is higher than that of a non-clearing
member.
No broker members are allowed to sit on the governing board of the clearing corporation
Trading Systems
At the end of each day the Exchange disseminates the aggregate open interest across all Exchanges in the
futures and options on individual scrips along with the market wide position limit for that scrip and tests
whether the aggregate open interest for any scrip exceeds 95% of the market wide position limit for that scrip.
If yes, the Exchange takes note of open positions of all client/ TMs as at the end of that day in that scrip, and
from next day onwards the client/ TMs should trade only to decrease their positions through offsetting
positions till the normal trading in the scrip is resumed.The normal trading in the scrip is resumed only after
the aggregate open interest across Exchanges comes down to 80% or below of the market wide position limit